Fed policy shift brightens future at CME

Growth in trading, profits could fuel new acquisitions

CME Group Inc.'s business is on the rise for the first time in five years, with a 52 percent jump in its stock price this year better positioning the world's largest futures exchange company for more growth.

The stock surge follows a 28 percent increase in CME trading volume this year over 2012, driven by a shift in Federal Reserve policy. The company is also benefiting from trading volume gains in its energy contracts and demand for its new swap-clearing services.

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Chicago-based CME is lifting itself out of doldrums that began when the 2008 recession put a damper on markets, continued with the Fed's decision to hold down interest rates and deepened in the past two years with scandals involving the collapse of futures brokers MF Global Inc. and Peregrine Financial Group Inc. Now, with profits up and a richer stock price, CME may be able to afford the kinds of acquisitions that eluded it in recent years.

“For the first time in a while, they're on the offensive,” says Chicago-based Sandler O'Neill & Partners analyst Richard Repetto, who at a conference last month coaxed CME Executive Chairman and Blackhawks fan Terry Duffy into agreeing that he's a goalie coming out to play forward.

On May 29, CME logged the biggest trading day of its 165-year-history, with nearly 27 million contracts changing hands. That day a Fed official signaled the central bank's plan to ease its buying of U.S. bonds, which has kept interest rates low. The new tack kicked up market volatility and gave traders a need to hedge interest rates with futures contracts.

CME “stock is very interest rate-sensitive,” former CME board member Robert Corvino says. “Volume has exploded.”

CME's advance also is fueled by gains in trading of its West Texas Intermediate crude oil contract, which had taken a backseat to rival IntercontinentalExchange Inc.'s Brent crude oil contract for more than a year but reclaimed top status recently after an oil distribution problem was resolved.

In addition, demand is climbing for CME's new swap-clearing services, thanks to the 2010 Dodd-Frank reforms that require the clearing of swaps.

The added revenue comes with little increased cost because an exchange's expenses don't rise much after volume breakeven points. CME expects a 2 percent cost increase this year. Mr. Repetto and other analysts recently raised earnings estimates, though they noted it's not clear the trend will last.

“I hate to overpromise and underdeliver—that's not anything I would ever try to do,” Mr. Duffy says. “The market has understood that lately, and it's rewarding us for delivering.”

CME's gains outshined those of the only other major U.S. futures exchange, Atlanta-based ICE, where trading volume has been flat this year compared with 2012. ICE has been busy digesting its acquisition of NYSE-Euronext, which will boost its threat to CME by expanding its reach not only with the iconic New York Stock Exchange, but also with international exchanges.

quote|Terry Duffy, executive chairman,CME Group Inc.

I hate to overpromise and underdeliver. . . . The market has understood that lately, and it's rewarding us for delivering."

CONSOLIDATION TREND

That transaction follows the industry's trend toward consolidation over the past 10 years. CME was created with the merger of the Chicago Board of Trade and Chicago Mercantile Exchange in 2007, and it bought the New York Mercantile Exchange the following year.

But CME missed recent opportunities, losing a bid for the London Metal Exchange and falling short in a run at the NYSE Liffe futures business. Its only exchange purchase in the past five years was the small Kansas City Board of Trade last year. While targets are dwindling, CME could go on the hunt again.

In the past, Mr. Duffy said he preferred to expand only in the futures business, partly because he wanted oversight from just one regulator, the Commodity Futures Trading Commission. (Buying a stock or stock options exchange would add the Securities and Exchange Commission.) That means grabbing the Minneapolis Grain Exchange would be natural because it's the only significant remaining U.S. futures exchange other than ICE.

Still, Mr. Duffy said at a recent analyst conference that answering to both regulators might not be so burdensome today. As a result, CME may be open to courting its crosstown cousin, options exchange CBOE Holdings Inc. But it won't come cheap: CBOE's stock price has surged 59 percent so far this year.

With Mr. Duffy and CME CEO Phupinder Gill on a mission to attract more international business, which accounts for a fifth of revenue, buying a foreign company with a futures business, such as Deutsche Borse Group, also would make sense.